Square and PayPal. The Future Big Banks.

Your smartphone is now your bank branch.

Part 1- Payment apps tap into our primal reciprocal instincts. This enables viral growth — low customer acquisition costs.

Part 2- Payment app user bases are growing fast.

Part 3- Market conditions are not entirely favourable to invest in this thesis today. I am waiting for some P/S ratio convergence between old and new banks.

Some time ago I read about the Principle of Reciprocity, which is a psychological concept that outlines how we humans have a tendency to be reciprocal to each other. This principle permeates our lives to a far deeper extent than it seems initially and makes up for much of the basis of our social fabric. It was in reading about this that I understood why payment apps grow so quickly.

When we owe someone money, due to this principle, we feel increasingly uncomfortable. Due to this discomfort, we resort to any method that will free us of it as quickly and as conveniently as possible. How many times have you been out for dinner and heard “Do you have <Payment App X> when the bill arrives? Or how many times have you said it yourself? Payment apps are the lowest latency method to comply with our primal reciprocal instincts and for this reason, they experience viral growth. We ask others to join the app / others ask us, because they have successfully tapped into this principle.

This translates into lower costs of acquisition per customer in the banking business, because each acquired user has a digital wallet. Cash app ($SQ) pays 20$ per MAU, whilst user cost of acquisition per line of business are estimated to be as follows:

If you already send / receive money from your digital wallet, then buying stocks, insurance and borrowing money, in the form of loans or credit, is next. A financial service provider would be able to deliver these services at a lower marginal cost, because they don´t have to operate physical branches anymore — just write some code.

To illustrate the above, consider this:

Because the inherent customer acquisition mechanism is far superior in payment apps, user bases are growing really fast. This means that eventually, these payment apps will yield large banks.

This does not mean that all legacy banks will disappear. Some will surely update their digital offerings and be able to compete in this environment. For instance, Zelle is the payments app with the largest payment volume in the US, with a total of 180bn USD transacted between users yearly. Zelle is co-owned by Bank of America, Wells Fargo, Capital One and others. Square´s yearly volume is 100bn USD and Venmo´s (owned by PayPal) is 90bn USD.

Even though Square has a POS solutions business (to help sellers make money) and PayPal has other businesses other than Venmo, it helps to look at both companies as if they only had the payment app business, to gain a clearer picture of the bottom line.

If you divide the market cap by the number of MAUs (monthly active users), you get the price the market is paying for each monthly user. Both in the case of Square and PayPal, this yields a price of around 4000$ per MAU, whilst the fair lifetime value per MAU is estimated to be around 2500$. Effectively, the market is discounting a 60% growth in the user base — this estimate is on the higher end, because with this simple calculation we are neglecting the cash flows from the other business areas.

Meanwhile, due to the pandemic, “old economy stocks” have suffered declines, relative to the newer economy stocks. For instance, BoA´s P/S ratio is at 3.3 today, whilst Square´s is at 16.3 and PayPal´s is at 15.2. JP Morgan´s price to sales ratio is at 3.56. The newer “banks” have a great deal of growth ahead of them and higher multiples are appropriate, but in my opinion there is some convergence to come.

Having said that, when / if the convergence does come along, it would be a good moment to set your sight on the banks of the future.

Investor, Technologist. Post opinions, not financial advice. Do your own research. Follow me at TW:alc2022

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